BA016IU

Fundamentals of Financial Management

Topic 8. Capital structure and cost of capital

Dr. Thy Nguyen

Content
• The cost of capital overview
• Determining appropriate discount rate for project evaluation

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Learning outcomes
After studying this topic, you should be able to:
• LO1: Calculate the weighted-average cost of capital.
• LO2: Understand when the weighted-average cost of capital is—or isn’t—the
appropriate discount rate for a new project.
• LO3: Measure a company’s capital structure.
• LO4: Estimate the expected returns on a firm’s securities.
• LO5: Use the weighted-average cost of capital to value a business given forecasts of its
future cash flows.

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Main textbooks Further readings

Brealey, R.A., Myers, S.C. and Marcus, Ross, S., Westerfield, R., & Jordan, B.
A.J., Fundamentals of Corporate Finance, (2022), Fundamentals of Corporate
McGraw Hill (any recent edition). – Finance, 13th Edition, McGraw-Hill
Chapter 13 Education. Chapter 14
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Websites
• [Link] Choose “Finance Tutor
Series”.
• Yahoo Finance at [Link]
• CNN at [Link]
• Wall Street Journal at [Link]
• The economist at [Link]

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THE COST OF CAPITAL
OVERVIEW

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COST OF CAPITAL – what is it?

What? Why needed?

The opportunity
Discount rate used to
cost investors face for
discount project CFs
investing their funds in
one business instead
of others with similar Minimum required
risk return needed on
projects (hurdle rate)

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WHAT ARE THE POSSIBLE CAPITAL COMPONENTS?

COST OF CAPITAL
Cost of
equity Cost of debts
(common Cost of (bonds)
stock) equity Cost of debts
(preferred (bank loans)
stock)

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THE WACC EQUATION
WACC = the weighted average cost of possible sources of capital
(Debt, Preferred stock, Common stock) by market value

WACC = E ( V ) R + (PV ) R + (DV ) R

E P D  (1 − TC )

E = market value of Common Equity RE = cost of Common Equity

D = market value of Debt RD = cost of Debt
P = market value of Preferred Equity RP = cost of Preferred Equity
V = E + D + P = market value of Firm TC = tax rate

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 A THREE-STEP PROCEDURE FOR
ESTIMATING FIRM WACC

Step 1 Step 2 Step 3

Identify Estimate the market Calculate after-tax
permanent value and required weighted average
sources of capital return of each of the costs of each
source of capital source of capital

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STEP 1. IDENTIFY THE FIRM’S PERMANENT
SOURCES OF CAPITAL
Include permanent sources of capital only!

❑ Include all classes of equity : preferred and common stock

❑ Include long-term debt
❑ Exclude seasonal short-term debt and accounts payable
❑ Exclude deferred taxes and other book liabilities that do not
generate capital

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STEP 2. DETERMINING MARKET VALUE AND
COST OF DEBT
Marketable Debt (Bond)
Use current market price to compute yield, or
Compute price using market yield

After-tax cost of Debt = Pre-tax cost of Debt x (1-tax rate)

RD = YTM (or EAR) x (1-tax rate)

Checkpoint 1: What is the after-tax cost of Debt on a corporate bond

that has par value = $1,000; coupon rate 8% paid annually ; time to
maturity 3 years and is currently trading at $900 if the tax rate is 30%?

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STEP 2. DETERMINING MARKET VALUE AND
COST OF DEBT
Non-marketable debt

Bank loan:
Use Book value to calculate weight
Cost of Bank loan: use current market interest rate on the loan (given)

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STEP 2. DETERMINING MARKET VALUE AND
COST OF COMMON EQUITY
Marketable equity
Use current market price for value
Use Gordon Growth Model (introduced in Topic 4) or CAPM (introduced in Topic
7) for cost of Equity

Do we have to
adjust for tax
when calculating
cost of Equity?

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STEP 2. DETERMINING MARKET VALUE AND COST OF
COMMON EQUITY
THE GORDON GROWTH MODEL
(Recalled…) If we assume that the dividend grows at a constant rate, g, the stock
can be valued as
D0 (1 + g )
P0 =
RE − g
Where RE is the cost of common equity and g is dividend growth
→ Rearranging, the cost of common equity is:
Where to get “growth rate”?
- From analyst’s forecasts
- Estimation using historical
D1 data
RE = +g
P0
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STEP 2. DETERMINING MARKET VALUE AND COST OF
COMMON EQUITY
ESTIMATING “G”

Year Dividend Dollar Change % Change

2000 $4.00 - -
2001 $4.40 $0.40 10.00%
2002 $4.75 $0.35 7.95%
2003 $5.25 $0.50 10.53%
2004 $5.65 $0.40 7.62%

→ Average growth rate = (10+7.95+10.53+7.62)/4 = 9.025%

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STEP 2. DETERMINING MARKET VALUE AND COST OF
COMMON EQUITY
THE GORDON GROWTH MODEL
Checkpoint 2:

In 2012, the CFO of Pearson (PSO) calls for an update of the firm’s cost of
capital. The 1st phase of estimation focuses on the firm’s cost of common
equity. How would the firm’s CFO determine the cost of the company’s
common equity, using the dividend growth model?

PSO stock is trading at $10.09. The last dividend paid is $0.47 per share, and we
expect a growth rate of 6.25%

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STEP 2. DETERMINING MARKET VALUE AND COST
OF COMMON EQUITY
THE CAPM APPROACH
(Recalled…) CAPM says that Required return on a risky investment depends on
three factors:

❑ The risk-free rate, Rf

❑ The market risk premium, (RM – Rf)
❑ The systematic risk of the asset relative to the average, 

RE = R f +  E  RM − R f  
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STEP 2. DETERMINING MARKET VALUE AND
COST OF COMMON EQUITY
THE CAPM APPROACH

Checkpoint 3: A review of current market conditions at the end of March 2009

reveals that the 10-year US Treasury Bond’s yield was 2.81%, the estimated
market risk premium was 6.5%, and the Beta for Drilling's common stock was
1.2

Determine Drilling's cost of common equity using CAPM, as of March 2009

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STEP 2. DETERMINING MARKET VALUE AND COST OF
PREFERRED EQUITY

Preferred stock pay a constant dividend every period.

Dividend is a perpetuity, so the cost is:
D RP is simply
Rp = the dividend
P0 yield!

D= Fixed Dividend; P0 = current price per preferred share

Checkpoint 4: Relay company’s preferred stock is trading at $25 per share. What
is the cost of preferred equity if the stock has a par value of $35 and pay annual
dividend of 4%?

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STEP 3. CALCULATE FIRM’S WACC
WACC = the weighted average cost of capital (Debt, Preferred stock,
Common stock) by market value

( V ) R + (P V ) R + (D V ) R
WACC = E E P D  (1 − TC )

Where V = Total value of firm’s assets

V = market value of Debt (D) + market value of Preferred equity (P)
+ market value of Common Equity (E)

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SUMMING UP: WACC CALCULATION
REQUIRES CONSISTENCY
Must include the opportunity costs from all sources of
capital

Must weigh each security’s required return by its

market-based weight, not historical book value

Must be computed after-taxed

Must be denominated in the same currency as cash

flows

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 DETERMINING APPROPRIATE
DISCOUNT RATE FOR PROJECT
Financial Management

EVALUATION

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WHEN CAN’T WE USE FIRM WACC TO DISCOUNT
PROJECT’S CASH FLOWS?
More than 50% of firms tend to use a single, company-
wide discount rate to evaluate all of their investment
proposals
This is wrong if new projects more or less risky than
its existing business

Each project should in principle be discounted using

its own opportunity cost of capital

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WHEN CAN’T WE USE FIRM WACC TO DISCOUNT
PROJECT’S CASH FLOWS?
Example
❑ Duke Power (a utility company) has low risk and thus low company cost
of capital
❑ Singapore Airlines has high risk and as a result, high company cost of
capital
❑ If both firms used its WACC to evaluate the SAME project (expands to
fast food industry), possible that
❑ Duke Power would accept the project
❑ Singapore Airlines would reject the project

EXPAND EXPAND

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WACC EXAMPLE 1: DURIAN LTD.

Equity Debt
❑P0=$2.40/share ❑$10 million face value,
❑15 million shares 8 years to maturity
❑Beta=1.2 ❑8% coupon rate
❑RM = 12% ❑6% market yield
❑RF =4% ❑Semi-annual coupons
Other
❑Corporate tax rate:
30%
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WACC EXAMPLE 2: PHILIPS EQUIPMENT
❑ Philips Equipment has 80,000 bonds outstanding that are selling at
par of $1,000 each. Bonds with similar characteristics are yielding at
6.75%.
❑ Phillips has issued 750,000 preferred shares that promise a 7%
dividend on $100 par value, currently sell in the market for $53 each.
❑Philips has 2.5m shares of common stock outstanding. The common
stock has a beta of 1.34 and sells for $42 a share.
❑ The US Treasury bill is yielding 2.8% and the return on the market is
11.2%. The corporate tax rate is 38%.
What is the firm’s WACC?

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